Know about Imported Inflation and Its Impact on India

IMPORTED INFLATION

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Context

The Asian Development Bank recently warned that India could face imported inflation as the Rupee could depreciate amid the arise of interest rates in the west.
A rise in interest rates in the west tends to cause the currencies of the developing countries to depreciate.

Imported Inflation:

Imported inflation refers to the increase in prices of goods and services in a country caused by an increase in the price or cost of imports into the country. This phenomenon can lead to higher overall inflation in the economy.

Impact of a Fall in the Rupee:

A significant factor contributing to imported inflation is the depreciation of a country's currency.
When the local currency depreciates, it becomes more expensive to purchase foreign goods and services, leading to higher import costs and potentially higher prices for consumers.

Rise in Import Costs Without Currency Depreciation:

Even without currency depreciation, a rise in international commodity prices, such as crude oil, can lead to higher import costs and inflation.
This concept is similar to cost-push inflation, where increased input costs lead to higher prices for final goods and services.

Criticism of the Concept:

Some economists argue that the idea of imported inflation is flawed. They suggest that it is consumer demand that ultimately determines prices, not input costs.
Producers decide what price they are willing to pay for inputs based on what they believe consumers will pay for the final goods.

Value Imputation:

Value is imputed from final consumer goods and services to the inputs used to produce them.
This means that input prices are ultimately determined by consumer demand for final products, not by the cost of inputs themselves.

Currency Depreciation and Demand:

Currency depreciation is seen as a reflection of higher nominal demand for imported goods, rather than the cause of higher import costs.
Therefore, imported inflation can be understood as a result of changing consumer demand for imported goods rather than currency depreciation directly causing higher prices.

IN A NUTSHELL,

What is imported inflation?

When the general price level rises in a country because of the rise in prices of imported commodities, inflation is termed as imported. India imports about three quarters of its total crude oil consumption. Therefore, if the oil prices go up in the international market, inflation in India will also go up due to higher prices of the petroleum products. Fuel and power has 14.91% weightage in the Wholesale Price Index in India.

However, it is not always necessary that only rise in the price of a traded commodity in the international market fuels imported inflation. Inflation may also rise because of depreciation of the domestic currency. For example, if the rupee depreciates by 20% against the US dollar in a particular period, the landed rupee cost of oil will also go up by the same proportion and will affect the price levels and inflation readings.

The fluctuation in global commodity prices works both ways. In fact, it is argued that low-priced exports from China resulted in low inflation over the years in the developed world, which allowed central banks such as US Federal Reserve to keep interest rates low for too long leading to an asset price bubble in the real estate market.

The policy response

Should central banks react to inflation going up or coming down because of price movement in the globally traded commodity? It is prudent on the part of the central bank to take imported inflation into account in policymaking as it affects the inflationary expectations in the country. RBI raised interest rates when oil prices were rising before the financial crisis of 2008. The Federal Reserve also raised interest rates in the 1970s to fight inflation when it was primarily driven by rising energy prices in the international market.

If the central banks decide not to intervene because of the imported nature of inflation, inflationary expectations will drive prices to much higher levels at which the central banks may lose control of the situation.

PRACTICE QUESTION

Q. Explain the concept of imported inflation and its economic implications. Evaluate the effectiveness of monetary and fiscal policies in mitigating the effects of imported inflation.

SOURCE: THE HINDU